Weekly Update - Budget rules review may be controversial but will be decisive for the euro zone

An essential review of the Stability and Growth Pact. The so-called Maastricht rules sought to restrict the debt European states could run up, a key structural issue for countries embarking on monetary union. They capped government debt and public sector deficits at 60% and 3% of GDP, respectively. These lines, often seen as pulled out of a hat, proved hard to hold in the wake of the 2008 financial crisis and were a key factor in the euro zone debt crisis that followed. The reaction to the Covid crisis was markedly different. European states quickly agreed to dump the rules and inject massive coordinated aid to their economies. Now, with the health crisis fading, a measure of fiscal discipline looks essential again, but under a revised framework that avoids past problems. The European Commission has launched a public consultation on what these rules should be and hopes to have the new framework in place by 2023.

Country-specific debt targets and free passes for some investments? The consultation document includes a broad spectrum of proposals at this stage. Reforms likely to make it through include tailoring sovereign debt targets to each country, taking account of the existing scale and viability of their debt, and backing this up with budget surveillance, at least for countries with debt running above 60% of GDP. The Commission is also considering not counting some types of public investment (e.g. green investment) toward the budget target, a proposal that has perked interest across the EU.

The debate will be lively but decisive for euro zone stability. One group of countries has already registered its objection to any rule review and wants a straight return to the 60%/3% ceilings by 2023. This could mean a fiscal clampdown that would be bad for the euro zone economy and potentially counter-productive in reducing state debt; if debt fell slower than GDP the ratio would deteriorate. That said, letting public debt keep growing on its current path is clearly unsustainable and would quickly imperil financial stability once again. Shifting political balances, with a new coalition in Germany, and looming elections in Italy and France, will be crucial to how the review pans out. The new coalition has yet to pronounce on the European framework but when it comes to Germany looks to be moderate at best, arguing for holding budget discipline and limited public investment.

Bottom line. Since the euro zone sovereign debt crisis, the ECB's asset purchase and refinancing programmes have damped down the yield gaps between zone countries and hence how much states have to pay for their finance. The debate about new
budget rules will be decisive for the future of this policy and the future credibility of the single currency.

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